NAME: __________________

TAKE HOME QUIZ 4

(Due on May 3rd)

ID#: _ _ _ _ _ _ _ _

(1) The following table describes yield curve in last three years. Suppose that
(i) market correctly predicted (and predicts) future interest rates;
(ii) term premiums were (and are) constant across these three years.
Fill the two empty boxes in the table. And show (below) how you found your answers.
Annual interest rate on bonds with maturity

Year 2004

Year 2005

Year 2006

one year

3.0 %

4.0 %

2.0 %

two years

_._ %

3.5 %

3.0 %

three years

4.0 %

_._ %

3.0 %

(2) Using IS-LM model (chapter 15) determine the impact of an unexpected contractionary monetary
policy on stock prices. If the effect is ambiguous, explain what additional information would be
needed to reach a conclusion.
(3) Using IS-LM model (chapter 15) determine the impact of an unexpected increase in consumer
confidence on stock prices. Also assume that
(i) as a result of interest being paid on money balances the LM curve has a negative slope;
(ii) central bank does not change its monetary policy.
If the effect is ambiguous, explain what additional information would be needed to reach a
conclusion.
SOLUTIONS:
(1) i(2004,two) = 4.0 %
(a) First we need to find a term premium on two-years bonds. Note that holding one-year bonds
in year 2005 and 2006 yields (on average) 3.0% interest rate per year. As the i(2005,two)=3.5%,
the term premium on two-years bonds is 0.5%.
(b) Next notice that holding one-year bonds in year 2004 and 2005 yields (on average) 3.5%
interest rate per year. As the term premium on two-years bonds is 0.5%, thus i(2004,two)=3.5%
+ 0.5%.
i(2005,three) = 4.0 %
(a) First we need to find a term premium on three-years bonds. Note that holding one-year bonds
in year 2004, 2005 and 2006 yields (on average) 3.0% interest rate per year. As the
i(2004,three)=4.0%, the term premium on three-years bonds is 1.0%.
(b) Next notice that holding two-year bond starting in year 2006 yields 3.0% interest rate per year.
As the term premium on two-years bonds is 0.5%, and as i(2006,one) = 2.0%, the expected
interest rate on holding one-year bond in year 2007 must be 3.0%.
(c) Finally, in year 2005 a three year bond must yield average interest rate on three one-year bonds
(average of 4.0%, 2.0% and 3.0% from years 2005, 2006 and 2007) plus the three year bond term
premium of 1.0%

(2) As interest rate goes up (for some time) and dividends down (for some time) the stock prices
decrease. For explanation and IS-LM graph see pages 324-5 from the text book for the opposite
example with monetary expansion.

(3) For impact of consumer confidence on IS curve see the page 325 in the textbook.
Recall the problem solved in lectures 11 and 12 that illustrated downward sloping LM curve.
As can be seen from the following two graphs, the answer depends on the relative slopes of IS
and LM curves (and that is given by values of the parameters that determine these slopes):
(A) If LM is steeper than IS interest rate increases, dividends decrease and stock prices go down.
(B) If IS is steeper than LM interest rate decreases, dividends increase and stock prices go up.
(We need to know which curve is steeper (has larger negative slope) than the other.)

(A) Stock prices down

(B) Stock prices up

LM

IS

IS
Y

IS

IS

LM
Y